Tax Reform

Reform Can Be a Lifeline for Public Pensions Hoping to ‘Tread Water’

This article was originally featured as the cover story for Tax Notes magazine in their October 12, 2020 edition.

Retirement savings took a major hit in the early half of 2020, as investment returns were deeply affected by the economic reactions to the pandemic — and public pension plans are no exception. Moody’s Investors Service has noted that public pension plans will have to increase their annual contributions to maintain current funding ratios (plan assets divided by plan liabilities), otherwise known as “treading water.”[1]

What pension plans need now more than ever is real reform. Rather than trying to keep up with rapidly growing annual required contribution (ARC) payments, pension systems should consider enrolling new hires in 401(k)-style defined contribution plans and implementing reforms to enhance existing pensions’ sustainability.

Underfunding Not a New Problem

Most public pensions can be described as following a defined benefit structure, in which public employees are provided with benefits based on a formula that takes into account an employee’s compensation while they were working, years of service, and age.[2] Contributions to these plans are often made by both employees and the state. The state’s ARC consists of normal costs for the year plus payments toward liabilities.[3]

Public pension funding, however, was not all roses before 2020. Despite impressive economic growth in the United States, the American Legislative Exchange Council annual report, “Unaccountable and Unaffordable,” found that risk-free unfunded pension liabilities totaled nearly $5 trillion (or $15,080 per capita) in fiscal 2018 and were growing.[4] Forty-one percent of those unfunded liabilities were concentrated in the five states with the largest unfunded pension liabilities: California ($780 billion), Illinois ($359 billion), Texas ($301 billion), Ohio ($290 billion), and New York ($277 billion).[5]

Of those states, Illinois is especially in distress. Decades of overpromising benefits and underfunding plans allowed unfunded pension liabilities to pile up. That left Illinois with the second largest unfunded pension liabilities and unfunded liabilities per capita (more than $28,000 per Illinois resident).

As unfunded liabilities climbed over several decades, retirement costs grew to more than a quarter of Illinois’s budget.[6] In hopes of catching up with growing costs, Illinois has some of the most crushing state and local tax burdens in the country.[7] Instead, residents are leaving the state in droves for states with more responsible public policies.[8] Over the past 11 years, Illinois’s credit rating has been downgraded 22 times by Moody’s Investors Service, S&P Global, and Fitch. Illinois’s credit rating now sits at BBB-/Baa3, which is just above junk status.[9] In a March letter to Illinois members of Congress, Illinois Senate President Don Harmon (D) requested a federal bailout of $44.2 billion, with $10 billion going directly to bail out pensions.[10] In May Illinois sold $1.2 billion in general obligation bonds via the Federal Reserve Municipal Liquidity Facility at interest rates well below market interest rates.[11]

While Federal Reserve aid is helping to keep Illinois afloat for now, the state was not required to make changes to spending or reform its pension system. The state will continue to overpromise and underfund pensions until it returns to the federal government, hoping for another bailout. States cannot afford to delay policy reforms until they are in Illinois’s situation. With unexpected funding shortfalls in 2020, states need real pension reform now more than ever.

Poor Assumptions Make Poor Pensions

One important aspect of public pension analysis is determining how those pension liabilities are measured, specifically what discount rate is used. The discount rate is used to determine the value today (present value) of pension promises owed in the future. The discount rate — expressed as a percent — should reflect a state’s inability to default on its pension promises.[12]

The Governmental Accounting Standards Board, a private organization that sets accounting standards for states and localities, allows pension plans to use relatively high discount rates (based on the return on investments for plan assets) for plan liabilities covered by assets and relatively low discount rates (based on the low-risk return on municipal bonds) for unfunded liabilities.[13]

Stanford economist Joshua Rauh and others, however, recommend only using the lower discount rates on all pension liabilities because it accurately reflects that pension benefits are legally guaranteed by the state.[14] For this reason, the ALEC report uses a risk-free discount rate based on the average yields of 10-year and 20-year U.S. Treasury Bonds as well as a fixed discount rate of 4.5 percent to control for rate changes over time.[15] Using these discount rates for all public pension plans also creates a common scale for pension liabilities to be measured.

While they may appear small, slight changes in discount rates can greatly affect the present value of liabilities.

Switching to Defined Contribution and Cost Sharing

Several states have implemented hybrid pension plans and options for full 401(k)-style defined contribution plans for new employees.[16] In most cases, a hybrid is a relatively small traditional pension plan offered in tandem with a defined contribution plan.

The traditional portion of these hybrid plans carries the same risks as traditional pension plans. The risks, however, are mitigated by the smaller size and often better contract terms — such as benefit formulas or higher employer contribution rates.

In 1996 Michigan was the first state to close its defined benefit State Employee Retirement System and enroll new hires in a defined contribution plan.[17] Similarly, Michigan transitioned its Public School Employee Retirement System to a hybrid system in 2017.

The latter plan auto-enrolls new hires in a defined contribution plan, but new teachers can opt into a hybrid plan with a mix of defined contribution and defined benefit plans.[18] The defined benefit plan splits all costs 50-50 between employers and employees while using a 10-year amortization schedule and a 6 percent discount rate. And if the hybrid plan’s funding ratio falls below 85 percent for two consecutive years, the plan is closed to new hires until the funding ratio rises above the 85 percent threshold for two consecutive years.[19]

However, other Michigan employee plans (such as the State Police Retirement System, State Judges Retirement System, Municipal Employees Retirement System, and Legislative Retirement System) kept the traditional pension option open to new hires. Thus, unfunded liabilities continue to accumulate in the state’s other pension plans.[20]

While states should consider the defined contribution option, policymakers should also look to Wisconsin for positive reforms to traditional pensions. Thanks to reforms passed by the Legislature and then-Gov. Scott Walker in 2011, the Wisconsin Retirement System incorporated several cost- and risk-sharing measures.[21]

These reforms included requiring all system participants (including public safety employees) to contribute half of all ARC payments for pension plans. Requiring participants and the state to split the ARC payment every year incentivizes prudent investment practices to minimize financial risks and annual costs.[22] These reforms have been successful, as Wisconsin was the best-funded pension system in the nation from fiscal 2012 to fiscal 2018.[23]

As lawmakers reconsider state financial plans for the years ahead, they should look to states that have made the switch to hybrid and defined contribution plans, as well as Wisconsin’s cost-sharing model. Only then will they be better able to weather the next unexpected economic downturn.

[1] James Comtois, “Public Plans to Face Major Losses in Fiscal 2020 — Moody’s,” Pensions & Investments (Mar. 25, 2020); “Moody’s — Maintaining Higher Contributions Is Crucial to Keeping Kentucky’s Pension-Related Credit Risk in Check,” Moody’s Investors Service (Sept. 11, 2020).

[2] Thomas Savidge et al., “Unaccountable and Unaffordable, 2019,” American Legislative Exchange Council (June 4, 2020).

[3] Id.

[4] Savidge et al., supra note 2.

[5] Id.

[6] Ted Dabrowksi, Mark Glennon, and John Klingner, “Solving Illinois’ Pension Problem: Part 1: Illinois is the Nation’s Extreme Outlier,” Wirepoints, Sept. 2020.

[7] Jonathan Williams, Arthur B. Laffer, and Stephen Moore, Rich States, Poor States (2008).

[8] How Money Walks, IRS Tax Migration Data.

[9] Dabrowski et al., supra note 6.

[10] Adam Schuster, “Why Congress Should Reject Illinois’ $44 Billion Bailout Request,” Illinois Policy Center (Apr. 23, 2020).

[11] Dabrowski, “Mismanaged Illinois Becomes First State to Borrow From New Federal Reserve Facility,” Wirepoints, June 4, 2020.

[12] Savidge et al., supra note 2.

[13] Sheila Weinberg and Eileen Norcross, “GASB 67 and GASB 68: What the New Accounting Standards Mean for Public Pension Reporting,” Mercatus Center at George Mason University (June 15, 2017).

[14] United States Senate & United States House of Representatives, Testimony of Joshua D. Rauh Before the Joint Select Committee on Solvency of Multiemployer Pension Plans (July 25, 2018).

[15] Savidge et al., supra note 2.

[16] Id.

[17] Anthony Randazzo, “Pension Reform Case Study: Michigan 2016 Update,” Reason Foundation (August 2016).

[18] Leonard Gilroy, Anthony Randazzo, and Daniel Takash, “Michigan Adopts Most Innovative Teacher Pension Reform in the Nation,” Reason Foundation (June 16, 2017).

[19] Id.

[20] Id.

[21] Kerri Seyfert, “The Wisconsin Retirement System Is Fully Funded and a Model for Other States,” Reason Foundation (Jan. 14, 2020).

[22] Id.

[23] Savidge et al., supra note 2.

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